Rationalize each numerator. See Example 7.2x + 12x - 1

Chapter 17 Notes Quantity theory of money Price rises when the government prints too much money Most economist believe the quantity theory is a good explanation of the long run behavior of inflation The Value of money P = the price level Price level- the price of a basket of goods, measured in money 1/P is the value of $1, measured in goods ex. If P = $2, value of $1 is ½ candy bar inflation drives up prices and drives down the value of money Money supply (MS) In the real world, the MS is determined by Federal Reserve, the banking system, and consumers In this model, we assume the Fed precisely controls MS and sets it at some fixed amount Money Demand (MD) Refers to how much wealth people want to hold in liquid form Depends on P An increase in P reduced the value of money, so more money is required to buy goods and services Thus, quantity of money demanded is negatively related to the value of money, and positively related to P, other things equal (these other thins include, real income, interest rates, availability of ATMs) as the price level falls, the value of money rises and vise versa The Fed sets MS at some fixed value regardless of P Perfectly inelastic A fall in the value of money (or increase in P) increases the quantity of money demanded Downward sloping, just like a regular demand curve P adjusts to equate quantity of money demanded with money supply Equilibrium price level Suppose the fed increases the money supply… Then the value of money falls, and P rises How does this work At the initial P, an increase in MS causes excess supply of money People get rid of their excess money by spending it on goods and services or by loaning it to others, who spend it Result- increased demand for goods But supply of goods does not increase, so price must rise Real vs. Nominal Variables Nominal variables- are measured in monetary units ex. Nominal GDP, nominal interest rate (rate of return measure in $), nominal wage ($ per hour worked) price is a nominal variable real variables- are measured in physical units ex. Real GDP, real interest rate (measured in output), real wage (measured in output) relative price is real variable relative price- the price of one good related to (divided by) another measured in physical units Real vs. Nominal Wage W= nominal wage = price of labor Ex. $15 per hour P= price level= price of goods and services Ex. $5 unit of output Real wage is the price of labor relative to the price of output W divided by P Classical Dichotomy- the theoretical separation of nominal and real variables Hume and the classical economists suggest that monetary developments affect nominal variables, but not real variables If central banks double the money supply, Hume and classical thinkers contend… All nominal variables – including prices – will double All real variables – including relative prices – will remain unchanged Monetary Neutrality- the proposition that changes in the money supply do not affect real variables Doubling the money supply causes all nominal price to double, the relative price is unchanged (real variable) Velocity of money- the rate at which money changes hands P X Y = nominal GDP (price level) x (real GDP) M = money supply V = velocity Velocity formula = (P x Y) / M Velocity is fairly stable over time The Quantity Equation Velocity Formula = (P x Y) / M Multiply both sides by M M x V = P x Y Called quantity equation Represents the entire economy What does the quantity equation tell you Velocity is stable So, a change in M causes nominal GDP (P x Y) to change by the same percentage A change in M does not affect Y Money is neutral Y is determined by technology and resources P changes by the same percentage as P x Y and M Rapid money supply growth causes rapid inflation Things to remember about the Quantity Theory of Money If real GDP (Y) is constant, then inflation rate = money grow rate If real GDP (Y) is growing, then inflation rate < money growth rate The bottom line: Economic growth increase number of transactions Some money growth is needed from these extra transactions Excessive money growth causes inflation Hyperinflation- generally defined as inflation exceeding 50% per month Caused by government printing too much money Excessive growth in the money supply always causes hyperinflation Inflation tax- the revenue from printing money When tax revenue is inadequate and ability to borrow is limited, government may print money to pay for its spending Almost all hyperinflation starts this way Printing money causes inflation, which is like a tax on everyone who holds money In the U.S. the inflation tax today accounts for less than 3% of total revenue The Fisher Effect Nominal interest rate = inflation rate + real interest rate In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate The nominal interest rate adjusts one-for-one with changes in the inflation rate This relationship is called the Fisher effect, after Irving Fisher who studied it The Fisher effect- an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate is unchanged In other words, a 1% increase in inflation causes a 1% increase in the nominal interest rate The cost of inflation Inflation fallacy- most people think inflation erodes real incomes or their purchasing power But, inflation is a general increase in price of the things people buy and the things they sell (ex. Labor), so incomes rise with inflation In the long run, real incomes are determined by real variables, such as human capital, physical capital, technology, and natural resources, not the inflation rate Nominal income = real income + inflation Shoeleather costs- the resources wasted when inflation encourages people to reduce their money holdings Includes the time and transaction costs of more frequent bank withdrawals Menu costs- the cost of changing prices Printing new menus, mailing new catalogs, etc. Higher inflation causes more frequent price changes which leaders to higher menu costs Earning interest on your money helps offset inflation Misallocation of resources from relative-price variability- firms don’t all raise prices at the same time, so relative prices can vary which distorts the allocation of resources Confusion and inconvenience- inflation changes the yardstick we use to measure transactions Complicates long-range planning and the comparison of dollar amounts over time Tax distortions Inflation makes nominal income grow faster than real income Taxes are based on nominal income, and some are not adjusted for inflation Inflations causes people to pay more taxes even when their real incomes don’t increase Arbitrary redistribution of wealth- higher-then-expected inflation transfers purchasing power from creditors to debtors Debtors get to repay their debt with dollars that aren’t worth as much Lower- than – expected inflation transfers purchasing power from debtors to creditors High inflation is more variable and less predictable than low inflation These arbitrary redistributions are frequent when inflation is high Cost of inflation All these costs are quite high for economies experiencing hyperinflation For economies with low inflation (<10% per year), these costs are probably smaller, though their exact size is open to debate